The 401(k) Unlevel Playing Field

The 401(k) Unlevel Playing Field

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With the Summer Olympics in Rio de Janeiro underway, sports are on my mind. There’s an unlevel playing field in the retirement planning world. Forgetting about defined benefit plans which are in a league of their own, 401(k) plans are the clear favorite for employees who want to save for retirement.

401(k) participants enjoy a decided advantage over those who don’t have access to these retirement plans when it comes to making contributions. This includes higher limits, greater ability to deduct contributions, ease of contributing to a Roth account, and potential employer matching contributions.

Higher Contribution Limits

The ability to accumulate a meaningful nest egg using traditional IRA and Roth IRA accounts is limited by several roadblocks that aren’t an issue with 401(k) plans. The most significant advantage of 401(k) plans over traditional and Roth IRAs is their contribution limit.

You can contribute up to the lesser of compensation or $18,000 to a 401(k) plan if you’re less than 50 years old. This is $12,500 greater than the maximum allowable IRA contribution of $5,500. The spread increases to $17,500 if you’re 50 or older, with limits of $24,000 and $6,500 for 401(k) and IRA contributions, respectively.

Greater Ability to Deduct Contributions

Pre-tax contributions to a traditional 401(k) are fully deductible. With traditional IRA plans, deductibility is potentially affected by participation in another retirement plan at work and marital status. If you or your spouse is covered by an employer retirement plan, then you must apply an income test based on your modified adjusted gross income, or “MAGI,” and tax filing status to calculate the amount of your deductible contribution.

Assuming that you’re covered by a retirement plan at work and you’re single, full deductions to traditional IRAs are allowed for MAGI of $61,000 or less, no deduction if MAGI is $71,000 or more, and a partial deduction is allowed for MAGI in between. The floor and ceiling for married filing jointly is $98,000 and $118,000, respectively.

If you aren’t covered by a retirement plan at work and you’re married and you file jointly, full deductions to traditional IRAs are allowed for MAGI of $184,000 or less, no deduction if MAGI is $194,000 or more, and a partial deduction is allowed for MAGI in between.

Ease of Contributing to a Roth Account

Employees may elect to make nondeductible contributions to a Roth account assuming it’s offered as part of their 401(k) plan. Furthermore, they may allocate contributions between traditional and Roth accounts as they see fit so long as their total contributions don’t exceed the IRS annual limits of $18,000 and $24,000 for those younger than 50 and 50 or older, respectively.

The ability to make Roth IRA contributions, like traditional IRA contributions, is limited by MAGI. If you’re single, Roth IRA contributions are allowed for MAGI of $117,000 or less, no contribution if MAGI is $132,000 or more, and a partial contribution for MAGI in between. The floor and ceiling for married filing jointly is $184,000 and $194,000, respectively.

Potential Employer Matching Contributions

Some 401(k) plans provide for employer matching contributions. A typical arrangement is the employer matches 50% of employee contributions up to the first 6% of salary.

As an example, suppose that your salary is $100,000, you contribute 10% to your 401(k) plan, and your employer matches your contributions using the typical arrangement. In addition to your contributions of $10,000 (10% x $100,000), your employer will contribute $3,000 (50% x 6% x $100,000) to your 401(k) account, resulting in total contributions of $13,000.

Importance of Retirement Income Planning

Whether you’re considering making contributions to a traditional 401(k), Roth 401(k), traditional IRA, or Roth IRA, you should do so within the context of a retirement income plan. A plan can be used to project the amount of after-tax income that you will receive from various sources beginning in a specified year for the duration of retirement.

You can prepare what-if scenarios to determine which types of retirement accounts, e.g., traditional vs. Roth 401(k), and annual contribution amounts are likely to optimize projected after-tax retirement income.  Your plan can, and should be, used to calculate gaps between projected retirement expenses and income. This in turn can be used to determine other types of non-retirement account investments and contribution amounts you should make to enable you to reduce the projected gaps and achieve your retirement income planning goals.

Deferred fixed income annuities should be included as part of your analysis since they’re designed for retirement income planning. Fixed income annuities, which generally aren’t offered in 401(k) plans, are the only investment that provides sustainable lifetime income. They also offer significant potential income tax savings and aren’t subject to IRS’ required minimum distribution rules when owned individually outside of a retirement plan.

While 401(k) plans enjoy many advantages on the front end, account values cannot be easily translated into projected retirement income streams. Whenever you invest in fixed income annuities, you know how much income you will receive each year beginning at a specified date with a given investment amount at the time of investment. This enables you to close projected income gaps with greater precision than is possible with 401(k) plans.

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